What are credit notes?

A credit note, also referred to as a credit memo, is an accounting document given by a seller to the buyer to compensate for fixing an invoice. Its purpose is to adjust or correct an invoice due to returns, overcharging, discounts not initially applied, and errors in billing.

It reduces the amount the buyer owes to the seller, ensuring accurate financial records. Credit notes can lead to refunds, adjustments, or compensation, depending on the situation, thus ensuring smooth financial records.

In most cases, a credit note works when an invoice that has been issued cannot be modified or deleted; a credit note helps to cancel the invoice as a new one is issued to the customer. These notes can be helpful for product returns as they help formalize a partial or full refund of a purchase to a customer. A credit note can be issued if:

• A product is damaged or delayed in transit.
• Not delivered after the invoice was issued
• If the order is withdrawn
• When an invoice is updated
• In case of erroneous billing on the original invoice

What is an example of a credit note?

Fashion boutique “Style Garden” purchases $1000 worth of clothing from supplier “Trendy Garments.” Upon receiving the shipment, Style Garden discovers that 50% of the items are damaged. Trendy Garments acknowledges the mistake and issues a credit note for $500, which is 50% of the original invoice value.

The credit note is applied to the original invoice, reducing the amount owed by Style Garden. Since Style Garden has already paid the original invoice, they can use the $500 credit towards a future purchase or request a refund. If the credit note had been issued before payment, it would reduce the amount due, adjusting Trendy Garments’ accounts receivable accordingly.

What information does a credit note include?

In a credit note, several things must be included to simplify things for the issuing company and the customer.

A credit note must be inclusive of:

• The date of issue
• The credit note number
• A customer or order reference number
• Payment terms and conditions
• Contact details of both companies
• Reason for credit note issuance

The document must be clearly identified as a credit note for differentiation from an invoice. In case value-added tax was included in the initial invoice, VAT must separately be added on the credit note.

How does a credit note work?

A credit note is a compensatory document that a seller creates to correct an invoice. A credit note ensures that a buyer’s account is corrected as required and cancels any miscalculation in the original deal.

Identification of Discrepancy

The process starts when a discrepancy is found, for example, an overcharge, incorrect delivery of the product, or faulty goods. The seller or the customer can bring this issue to the attention, emphasizing the need to rectify the invoice.

Issuing the Credit Note

After confirming the discrepancy, the seller creates a credit note. The credit note comprises necessary information like the reference to the original invoice, the credit amount, the reason for issue, etc.

Adjustment in Accounts

The credit note is posted in the accounting system of the business. This decreases the buyer’s amount due. Depending on circumstances, the buyer is refunded or the amount is offset for future purchases. For the sellers, this makes their books correct.

Application of Credit

Lastly, the credit note is posted to the buyer’s account. If a refund, the money is given back to the customer. Otherwise, the credit may also be utilized as a discount from the subsequent payments. Clear verbal communication to the customer about the credit note is essential in order to keep the customer trusting and open with the transaction. When issuing the credit note, both parties should clearly know about the adjustment.

What is the difference between a credit note and a reverse invoice?

A credit note and a reverse invoice are used for the same purpose but with minor differences:

Credit Note:

• Used to offset or cancel an amount on an existing invoice.
• Generally used for partial or full credits because of returns, damages, or overcharging.
• Does not cancel the original invoice but offsets the amount due.
• Can be used on future purchases or refunded.

Reverse Invoice (or Credit Invoice):

• Used to fully cancel an original invoice.
• Generally employed when an invoice is faulty or replaced by a new one.
• Reverses the original invoice, making it void.
• Commonly employed when a new invoice with amended information will be provided.

It can be said that a credit note amends an invoice, whereas a reverse invoice abolishes it. Based on your scenario, you can benefit from either, depending on the kind of issue with your invoice.

What are the benefits of a credit note?

There are numerous advantages linked with credit notes; they include

Avoidance of errors in reporting

The credit note helps to record all errors in invoicing for smooth business operations. It gives leverage to businesses and buyers to fix mistakes and avoid them in the future.

Early detection of errors

Credit notes ease businesses error tracking by recording them early. This helps to avoid repetitive mistakes in the future. Moreover, errors can be recorded and archived as learning instances for the future.

Improves client-business relationship

Credit notes can be used as guarantee notes to clients in transactions. In the short term it may seem like a loss for the business as it reduces accounts receivable. In the long run, it can help build a relationship of trust and transparency with the customer. This trust building and loyalty is critical to uplift brand repute.

Increased business operational efficiency

Credit notes or memos can help gauge past mistakes and correct them in the future. They help evaluate and increase the operational performance of businesses.

Helps avoid conflict

A credit note helps avoid conflict when discrepancies arise in transactions, such as returns, overcharging, or damaged goods. By providing a clear and transparent record of adjustments, credit notes prevent misunderstandings, demonstrate fairness, and resolve issues efficiently, ultimately maintaining positive business relationships and reducing the likelihood of disputes.

Improved cash flow

Smooth management of business cash cashflows is critical for your business health and financial property. The issuance of credit notes enables smooth inflow and recording of funds, thereby reducing the outstanding balance owed by customers. As soon as a credit note is issued, it offsets the amount owed, helping the business to collect the remaining balance easily. It allows healthy cash cashflows and ensures that your business runs well, meeting all the financial obligations.

Smooth Inventory Management

Credit notes are important for smooth inventory management in your business. When items are returned or adjusted, the issuance of credit notes allows for close tracking of stock available and stock sold. This information holds importance as it allows help with necessary stock-related decisions such as when to restock and production as well as quality control.

Accounting Accuracy

Credit notes ensure that financial records are accurate and up-to-date, allowing businesses to maintain precise accounting and reflect the true financial position of the company. This accuracy is crucial for making informed business decisions, preparing financial statements, and complying with tax regulations. With accurate accounting, you can take any suitable decision for your company with ease.

Why is a credit note issued instead of reissuing the invoice?

Issuing a credit note rather than reissuing an invoice has several purposes and can be beneficial in some cases:

Simplifying the Process: Issuing a credit note is usually faster and more convenient than reissuing an invoice.

Preserving Document History: The initial invoice stays whole by providing a credit note, keeping a full record of the first transaction. This is vital for both accounting and auditing.

Transparency and Clarity: Issuing a credit note makes it obvious that an adjustment has been done to the initial invoice and why the adjustment was done.

E-invoicing Compliance: Legal requirements of credit note issuance in Malaysia exist for the e-invoicing process.

What are some best practices for credit notes?

Make Sure Credits Are Issued in a Timely Manner

Credit notes are most effective when issued timely. Issuing a credit memo prior to the payment of an invoice enables the customer to simply deduct the amount they pay and ensure that the payment is processed in a timely manner.

Your customer might find themselves with a credit on their account that they can’t apply if you wait to issue a credit memo.

Use Journal Entries Properly

You must not forget to enter the credit or debit memo issued in the journal. In case you issue a note and don’t enter it correctly in the journal, your accounts will be incorrect.

Journal Credit Notes Against the Corresponding Invoices

The recipients of the credit memo should always attach a copy of the memo to the original invoice for audit purposes. By doing that, should the document come under selection in an audit, there will be an easy-to-follow paper trail to hand to describe the invoice amount and adjustments that were appropriately made.

Determine Why You’re Issuing Too Many Credit Memos

If you are finding that you are issuing many credit memos, spend a while figuring out why. Whereas lost and broken shipments are no longer in your control once you’ve sent them out from your business, when you have to give out several credit memos due to the quality of the products or the incompleteness of the shipments, you will have to evaluate your shipping methods or consider acquiring better materials with which to sell.

Automate Your AP or AR Process

If you’re still using manual processes, managing credit memos, whether as the buyer or the seller, requires a great deal of work. By making the transition to using accounts payable automation software or accounts receivable automation, credit memos will be recorded when issued.

What are the different types of credit notes?

Credit notes have various types. Here are a few for you to better understand how credit memos work.

Incoming credit notes

It is a document received by a business indicating a decrease in the amount owed on an invoice due to the return of goods, a discount, or overcharging on goods. For example, you order $1000 worth of goods but later return $200 due to defective items. The supplier in this case issues an incoming credit note for $200.

Outgoing credit note

This type of credit note is issued in case of errors or returns. For instance, you sell products for $60, but the customer finds some flaws or damage to the product and returns it. You issue an outgoing credit note to reduce the payable amount.

Issuance of a credit note helps maintain financial records. It allows buyers and sellers accounts to be updated and balanced. In the absence of credit notes, discrepancies can cause disputes, errors, and accounting mishandling. Moreover, credit notes allow transparency of transactions and payments with customers.

Why is a debit note issued?

A debit note is most usually raised when a portion of a delivery or shipment of goods is being returned to the seller due to the fact that the returned goods are defective or damaged. The debit note is returned with the returned goods, describing in detail to the seller why the goods are being returned. Also, it shows the amount to which the seller must alter its invoice to the buyer, deducting the amount due for the sale by the correct amount.

A purchaser may also write a debit note since the vendor did not deliver the goods within a specified time or date or by or on a stated date.

If the buyer has already settled the full invoice from the seller, then the debit note can state a partial refund to the buyer or compel the seller to advance a credit amount to the buyer’s account that will offset the amount due on subsequent purchases.

Example

Suppose that Company A purchases 10,000 widgets on credit from Company B for a specified price of $1.00 per widget. Company B ships the 10,000 widgets and later prepares and bills Company A an invoice for $10,000. Yet, when receiving the widgets, Company A’s warehouse crew discovers that 580 of the widgets are defective and cannot be used.

Company A will subsequently issue a debit note to Company B with the return of the 580 defective widgets, stating that Company B must, in turn, debit Company A by $580.00 for the amount owed.

After the transaction:

• Seller will debit its accounts receivable by $580.
• Buyer will credit its accounts payable by $580.

Debit Notes from Sellers

Debit notes that a seller sends to a buyer typically have one of two functions. First, a debit note can simply be sent as a reminder of a previously billed amount due on a sale. In this case, the debit note is merely a “bill payment due” reminder.

Second, a seller can issue a debit note when it finds that it needs to correct a presented invoice, raising the amount payable by the buyer. For instance, the seller can find that it billed the buyer $6,000 when the correct amount payable for the sale is $7,000. It will issue a debit note to the buyer for the extra $1,000, accompanied by a reason for the variation in the amount billed.